Greetings, fellow Psychonauts. I'm posting this because when I first played the game, I loved the Milkman level (who didn't) but my puny little thirteen-year old brain didn't fully comprehend the entire thing. I recently re-discovered the game and now believe that I can explain every aspect of the conspiracy. However, I was unable to find a satisfactory explanation online that would confirm or deny my theory. Give it a read and tell me what you think! If you disagree, well, this is a forum, so let me know your take on the whole thing. If you like what you see, but want me to explain other levels or elements of Psychonauts, just say so!
So to start to unravel this whole thing, we need to look at Boyd Cooper's background. Through memory vaults, we can learn the following: Boyd was a security guard for a store called Hernando's, but was fired. In an act of revenge, he set fire to the building using improvised Molotov cocktails made of empty milk bottles. He was then committed to Thorny Towers, where he was "commissioned" by Coach Oleander to guard the asylum and use his explosive milk bottles once again to destroy the asylum and the evidence contained within once Oleander's plan was complete. Oleander used Boyd because he was A) insane and B) experienced in burning things down.
Oleander hypnotized Boyd to ensure his cooperation and from that, we get the Milkman conspiracy. I'll run down the list of characters and describe their role in Boyd’s mind.
The G-Men: The G-Men are those serious, trenchcoat-wearing fellows who speak ultimate truths. They also represent Boyd’s extreme paranoia. Subjects of hypnosis do not remember the actual act of hypnotizing, so Boyd KNOWS something is wrong in his mind, but he cannot figure out what it is. From this problem came his intense paranoia. In the memory vault, we see that Oleander used a glass of milk in hypnotizing Boyd, so Boyd knows it has something to do with “the Milkman.” In his mind, the G-Men that Raz encounters are manifestations of this attempt at finding out what is wrong. The G-Men are looking for the Milkman, and they let it slip that they are “secret agents.” They assume all their different roles (road crew worker, grieving widow, etc.) in order to fit in with Boyd’s mind and search his entire mental world. All this secrecy and doubt is common with subjects that are paranoid. It is also for this reason that the G-Men and the censors work together at the end of the level. As we know, Censors want to get rid of anything that is foreign to the subject’s brain, and the G-Men are doing the exact same thing, thus they join forces.

The Rainbow Squirts and the Den Mother: These character’s represent Oleander’s attempt to prevent Boyd from figuring out the fact that he is hypnotized. After all, part of their “Pledge of Purpose” states they must “obfuscate the true nature of the Milkman.” They take the form of Rainbow Squirts because as we see in the vault, Oleander included cookies in the process of hypnosis, and organizations of young girls *coughGirlScoutscough* often sell cookies, and these groups usually have a leader, or a den mother. Also, cookies just go great with milk, so it stands to reason that they would work together. Since Oleander is a trained psycho-master and Boyd is a barely sane security guard, the Squirts are able to successfully protect the Milkman because Oleander is stronger than Boyd, therefore his defenses can withstand the efforts of Boyd’s mind.

The Milkman: The Milkman represents Oleander’s presence in Boyd’s mind. He looks like Boyd because of the hypnosis. When Boyd burns down the asylum, it is his body doing the action, but not his own idea to do so, hence the Milkman would appear to be the same as Boyd, but is in fact an entirely different character. After Raz leaves Boyd’s mind, the Milkman becomes the dominant personality in Boyd’s mind because of the battle at the end of the level. If you re-enter Boyd’s mind after beating the level, you see the Milkman repelling and completely laying waste to the censors. By “beating” the level, Raz has accidentally awakened the destructive nature deep inside Boyd and now he is the Milkman.
So why is the Milkman lying in a tomb and not controlling Boyd’s mind when you meet him? Well, Oleander needs Boyd’s skills as a security guard to protect the asylum. Also, Thorny Towers is needed for Dr. Loboto’s lab. If the Milkman destroyed it before the Brain Tanks were complete, all progress would be lost. When you fight the Den Mother, she says “The Milk is not ready.” In other words, Oleander’s plan isn’t yet completed, therefore it is not time to destroy the asylum.
Well folks, that about wraps everything up. I got everything I could think of. If there’s anything unclear or if you want me to explain any other elements of this game, just ask!